Public Disclosure Authorized
51626
The World Bank
PREMnotes
Taxing Consumption
Public Disclosure Authorized
Richard M. Bird*
Domestic consumption in most countries
is taxed through general sales taxes, ex-
cise taxes on specific commodities, and
a variety of miscellaneous taxes on such
services as hotels and transfers of prop-
erty. This note considers only the first
two of these categories, with particular
Public Disclosure Authorized
attention to general sales taxes.1
Consumption taxes are obviously
related both to customs duties and other
taxes on imports and also to produc-
tion taxes like those often imposed on
agricultural output. In some countries
elements of both import and produc-
tion taxation remain. These aspects are
not further explored in this noteother
than to note that the original form of
general sales taxes often consisted of
a sales tax imposed on imported and
Public Disclosure Authorized
domestic manufactured goods.
Most countries have now replaced
such pre-retail sales taxes by taxes that
fall primarily on consumption rather
than on production and, it is hoped, are
both more responsive to revenue needs
and easier to collect effectively and effi-
ciently. However, excise taxes on specific
commodities are often still imposed at
the production stage.
*The views expressed in this note are the authors and must not be represented as those of The World Bank. This
note was reviewed by Milan Brahmbhatt, Tuan Minh Le and Eduardo Ley.
FROM THE POVERTY REDUCTION AND ECONOMIC MANAGEMENT NETWORK
JUNE
TAX POLICY
2009
N U M B E R 136
Why VAT is the Sales
Tax of Choice2
There are essentially only three types
of general sales taxes: a turnover tax,
a single-stage sales tax, and a VAT. A
turnover tax is in some ways the easiest to
administer. Tell me your turnover, and
Ill tax you on it. The basic administra-
tive problem is to determine and verify
the turnover (sales) of a taxpayer and to
collect the tax. The idea is simple but its
execution can be difficult. The basic way
to evade such a tax is also simple: hide
(under-report) sales. The easiest way
legally to avoid the tax is by integrat-
ing vertically with ones suppliers since
within-firm sales are not taxed. The
other side of this coin, however, is that
a turnover tax is by far the economically
most distorting form of sales tax. Only
in the unlikely event that one wishes to
discourage exports and investment and
to induce firms to integrate up and down
the chain of distribution and production
are the allocative effects of such a tax
likely to be welcomed. Moreover, since
the final tax burden borne by any partic-
ular transaction depends essentially on
how many prior taxed transactions are
embodied in its sales price, its distribu-
tional impact is indeterminate. Govern-
ments that impose turnover taxes have
little idea of the effects of such taxes on
either allocation or distribution.
To avoid all these problems, one
obvious solution is to impose a single-
stage sales taxcommonly called a retail
sales tax (RST)on the final sale to con-
sumers (households or nonregistered
firms).3 Investment goods purchased
by registered firms, like other inputs
purchased for business purposes, are in
principle freed from tax, as are exports.
The allocative and distributional effects
of such a tax are much clearer than those
of a turnover tax. The government can
figure out what it is doing. Unfortu-
nately, experience with RSTs even in
countries with good tax administrations
demonstrates that this approach has two
fatal flaws. First, it is extremely difficult
to ensure that inter-firm purchases used
to produce taxable goods and services
and only those purchasesare exempt
from tax. The ring (or suspension)
system used to achieve this resultun-
der which tax is suspended on sales by
one registered firm to another and so on
and on until there is a sale to someone
outside the ring of registrantsis both
cumbersome to police and easy to abuse.
Second, the entire tax collection process
rests on the least dependable link in
the chainthe final sale to a consumer
(someone outside the ring of licensed
firms). The fragmented and usually
small-business-dominated retail trade
sector is notoriously difficult to police
in any country.
Hence the dilemma: turnover taxes
are easier to administer but have bad
economic effects; single-stage retail sales
2 PREMNOTE
taxes in theory avoid the bad effects
(though in practice they are unlikely to
do so very cleanly) but they are difficult
to administer well.
Enter the VAT. In principleand,
when properly set up and run, in prac-
ticeVAT combines the good features
of both its competitors while avoiding
the bad features for the most part. It
does this through two features: First, VAT
collects the equivalent of a single-stage
retail sales tax through a multi-stage col-
lection process that collects tax at each
stage of the chain of production and
distribution preceding the final sale to
households. By doing so, in the end it
achieves the (presumed) goal of taxing
only consumption. Moreover, even if
evasion occurs at the final retail stage
only that part of the potential tax base
consisting of the retail margin escapes
tax. Second, by crediting taxes on inputs
including capital goods, VAT avoids dis-
torting economic choices with respect to
production technology. It also eliminates
taxes on exports by crediting taxes paid
on inputs at prior stages.
With an RST as with a turnover tax
the basic way to evade is simply to avoid
reporting sales. This can be done by re-
maining in the shadow economy, by not
keeping proper books, or by not report-
ing correctly to the tax authority. It takes
only one to evade. With VAT, however,
there are two ways to evade: by under-
reporting sales or by over-reporting
taxable purchases (thus claiming excess
input tax credits and, in some cases,
even refunds). On the other hand, with
VAT it also takes two to evadea seller
and a buyer. Moreover, since the two
sides of the transaction are recorded in
two sets of books the task of the admin-
JUNE 2009
istration in detecting evasion should be
easier with VAT.
Indeed, in principle, the task of
the taxman is made even simpler be-
cause the two parties involved in any
potentially taxable transaction (buyer
and seller) have conflicting incentives.
Buyers want to overstate purchase prices
to inflate credits, while sellers want to
understate sales to reduce output taxes.
For this reason, some early writers even
claimed that VAT was at least to some
extent self-enforcing. In practice, in
some instances, this apparent strength
of VAT has proven to be a weakness in
the sense that it perhaps induced some
countries to rely too heavily on tax
design (the VAT approach to sales taxa-
tion) to do the work that only good tax
administration can really do. A major
form of VAT evasion in many developing
and transitional countries plays on this
feature of VAT: a firm creates a shell
company and then sells inputs to itself
at a false price that then serves as the
basis for an input tax credit or refund
claim. It is easier to get away with this
dodge when the alleged supplier is in
another country (as in the case of the so-
called carousel frauds in the EU). But
when the tax administration is as weak
as it is in many developing and transi-
tional countries it is not hard to create
and register fictitious firms domestically
in order to operate such frauds.
Nonetheless, despite such problems,
both in principle and practice it remains
simpler to enforce a sales tax applied
in an incremental value-added form
to a chain of transactions than when
all stands or falls on honest reporting
of a single transaction (the final sale).
Countries that have VATs, as most now
JUNE 2009 PREMNOTE
do, should keep them and improve them
as necessary; countries that do not have
VATs should consider adopting them.
Some Key Issues in VAT Design
The key design issues in any general
consumption tax include such matters
as rates, exemptions, the treatment of
small businesses, the treatment of excise
goods, and the appropriate treatment of
imports and exports. Only a few critical
points about sales tax design are noted
here.4 For example, the best sales tax
with respect to both efficiency and ad-
ministration is undoubtedly one with
a single uniform rate applied to all taxable
transactions. The usual reason for impos-
ing more than one rate is that it is more
equitable to do so, but this conclusion
is disputable for a number of reasons:
more rates make it harder to administer
a sales tax, differentiated rates mean
that a higher average rate is required to
raise a given amount of revenue (thus in-
creasing the economic costs of imposing
the tax), higher rates on luxury goods
are an ineffective means of increasing
the progressivity of the fiscal system,
and, most importantly, lower tax rates
on necessities are generally poorly
targeted and ineffective. The rich may
spend relatively less of their income on
basic food, but they are likely to spend
absolutely more and hence receive more
benefit from such concessions.
Although the most broad-based
consumption taxes in the world (such
as the New Zealand VAT) come close to
including most final (private) consump-
tion in the tax base, most VATs in de-
veloped countries probably encompass
50-60 percent of such consumption. The
general sales taxes found in developing
3
countries generally do considerably
worse in this respect, often tapping little
more than 30 percent of the theoretical
consumption tax base. The broader the
base the better since the rate required
for any revenue is obviously lower, which
means that the efficiency cost of raising
revenue is correspondingly lower. With
a broader base, administration is also
simpler because there are fewer avenues
of escape.
Full taxation of consumption can
never be achieved because it is not pos-
sible to tax some consumption (such as
home-produced consumption). It may
also be economically inadvisable to
do so, or there may be no net revenue
gain from doing so, or it would be too
costly to do so. Examples found in most
jurisdictions in addition to financial
services are public sector consumption,
education, health, and agriculture.
Most countries simply exempt activities
carried out under these headings from
tax. This common practice obviously
leaves a lot of consumption out of the
tax base and creates a number of eco-
nomic inefficiencies and administrative
complexities.
Finally, in part because VAT compli-
ance costs are particularly high for small
business, many countries have intro-
duced various forms of special treatment
for small traders. Current thinking is
that in practice most developing coun-
tries should likely have relatively high
thresholdssay $100,000at which to
require firms to register for VAT. 5 Reg-
istrants should, of course, be required to
keep at least minimal booksessentially
records of sales and purchases. If the
VAT is moderately well designed and
operated, registrants should come into
4 PREMNOTE
the system voluntarily since it will be so
clearly in their interests to do so. If they
do not, in so far as they deal with the
registered sector they will pay a fiscal
penalty and the interests of both equity
and competitive efficiency should, at
least roughly, be served.
Excise Taxes6
In most tax systems around the world
selective taxes on consumption, or ex-
cises, produce a significant amount of
revenue. Excises on alcoholic beverages,
tobacco, motor vehicles, and fuels are
generally the only items with sufficiently
high revenue yields to warrant special
attention.7 Such taxes have proven to be
both administratively feasiblethe im-
portation, production, and consumption
of excise goods are reasonably identifi-
able and reachable by the tax admin-
istrationand politically acceptable.
They produce considerable revenue
without giving rise to excessive evasion
and resistance. In addition, excises on
these items may reduce externalities
associated with drinking, smoking, and
driving.8
On the whole, these products should
in principle be taxed at rates set both
to offset externalities arising from their
consumption and for revenue reasons.9
Specific taxes levied as a flat amount
per physical unit of the good greatly
simplify administration. The tax in-
spector only needs to be able to count,
and does not have to worry about the
often troublesome issue of valuation.
In addition, to the extent one objective
of excise taxation is to discourage the
consumption of the taxed good, as in
the case of alcohol and tobacco, it seems
only sensible to impose the tax on, say,
JUNE 2009
the alcoholic content of the beverage
and not on value. Of course, specific
taxes also have problems: for example,
they may prove difficult to change in
the face of inflation, with the result that
real revenues may fall in the face of price
increases, and they may discriminate
against relatively cheaper products. On
the other hand, ad valorem taxes raise
valuation problems, hence complicat-
ing administration, and discriminate in
favor of cheaper products. In practice,
the choice of specific or ad valorem rates
usually comes down to how one weighs
the administrative advantages of the
former against the potential revenue
loss in the face of inflation. Although
it is seldom done, in principle specific
rates should be periodically adjusted to
keep real tax rates constant.
On the whole, international experi-
ence suggests that the specific tax ap-
proach is probably best in administrative
terms when one attempts to impose
high taxes on a few products that can
be fairly tightly controlled. Moreover, to
the extent excise tax policy is designed
with social objectives in mind, the spe-
cific approach is also indicated. Periodic
review and revision of specific rates is of
course needed in order to maintain both
revenue and social objectives in the face
of inflation.
The effective administration of a
high-rate excise tax fundamentally de-
pends upon establishing an adequate
system of control of the physical com-
modity. Physical control may be costly,
and may open the way to corruption
(since the tax inspector can be paid off
to certify tax payment). Nonetheless, for
alcohol, tobacco, and petroleum prod-
ucts, where there are generally few pro-
JUNE 2009 PREMNOTE
ducers or commercial importers, such
control at the production and import
level seems essential in most develop-
ing countries. Since vehicles need to be
registered and licensed, there is also an
opportunity to exercise the high degree
of control needed to enforce high rate
excise taxes.
Notes
1. For a detailed discussion of service taxes
in a specific context, see The Taxation of
Services, in Roy Bahl, ed., The Jamaican Tax
Reform (Cambridge, MA: Lincoln Institute
of Land Policy, 1991), pp. 433600. Taxes
on property transfers are considered in R.M.
Bird and E. Slack, International Handbook
of Land and Property Taxation (Cheltenham,
UK and Northampton, MA: Edward Elgar,
2004). A good recent overview of consump-
tion taxation in developed countries may
be found in OECD, Consumption Tax Trends
(Paris, 2006).
2. The section draws on R.M. Bird and
P-P. Gendron, The VAT in Developing and
Transitional Countries (Cambridge University
Press, 2007), chapter 3.
3. Few other forms of single-stage sales
taxes (those imposed prior to the retail level)
exist, and all suffer to varying extents from
the problems of turnover taxes.
4. For detailed discussion of these and
other issues, see the book cited in note 2
above.
5. See Michael Keen and Jack Mintz
(2004), The Optimal Threshold for a Value-
added Tax, Journal of Public Economics, 88:
55976.
6. For an excellent recent discussion of
excise taxation, see S. Cnossen, Theory and
Practice of Excise Taxation (Oxford: Oxford
University Press, 2005). Aspects relevant
in developing countries are discussed in
5
Cnossen, Excise Tax Policy & Administration
in Southern African Countries (Pretoria: Uni-
versity of South Africa, 2006).
7. Instead of applying differential VAT
rates to such products, best practice is to
apply the standard VAT rate to the price of
the product including excises.
8. The economically relevant externalities
arising from these activities are of course not
the costs directly imposed on the user but
rather the consequences that his actions may
impose on other members of society.
9. Motor vehicle taxes are usually progres-
sive in their distributional impact and, both
for this reason and because it is administra-
tively not difficult, are often subject to ad
valorem rather than specific taxes.

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